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George F. Bearup, J.D. Senior Legal Trust Advisor

27-Nov-19

Residence Held In Trust

Take-Away: Some commentators have suggested the transfer of title to a residence to a non-grantor trust to circumvent the 2017 Tax Act’s $10,000 deduction limitation on state and local taxes (SALT) as the trust is a separate income taxpayer with its own itemized deductions. While that planning step may be attractive,  it is important to keep in mind that IRC 121 may not be available if that residence is sold, and that other expenses associated with the residence held in the non-grantor trust are not deductible.

Background: IRC 121 provides a tremendous tax break for capital gains incurred on the sale of an individual’s principal residence. IRC 121 excludes $250,000 from capital gain recognition for an individual when their principal residence is sold,  or $500,000 for a married couple who sell their principal residence.

  • Old Law: IRC 121 replaced an earlier code section that many individuals still believe exists, when it is now ancient history, and has not existed for several years now. The old tax rule provided that capital gains recognized on the sale of a principal residence could be avoided (deferred) if all the net sales proceeds were used to purchase a replacement dwelling within two years. That is no longer the rule; it was replaced by the dollar limits described in IRC 121.
  • Qualification ‘Tests’: To qualify to claim the IRC 121 exclusion (or deferral) of capital gain on the sale of the principal residence the individual must meet both an ownership and a use test. The ownership test is that the dwelling must be owned  for at least 2 of the last 5 years prior to the sale or exchange of the dwelling. The use test is that the individual must not have used the IRC 121 exclusion for a disposition that occurred during the 2 years prior to the sale or exchange. A partial reduced IRC 121 exclusion may be available for an individual who does not meet these
  • Married Couples: The maximum amount of gain that may be excluded by a married couple who file jointly in the tax year of the sale or exchange is $500,000, but only if: (i) either spouse meets the ownership test with respect to the real property; (ii) both spouses meet the use test with respect to the real property; and (iii) neither spouse excluded gain on a sale or exchange of a principal residence within the prior two years. [IRC 121(b)(2).] A married couple’s exclusion is determined on an individual basis.
  • Example: Assume a couple recently married. Wife sold her home two years ago using IRC 121. She married husband who has lived in his home for 10 years. Wife moves into Husband’s home. They are now selling Husband’s home. Only Husband can use his full $250,000 exclusion, but Wife cannot.
  • Surviving Spouses: A surviving spouse may use the full $500,000 exclusion if the sale of the primary residence occurs within 2 years after the other spouse’s death and both spouses satisfied the three requirements noted above. [IRC 121(b)(4).]
  • Partial Ownership: Sometimes a 50% tenant in common interest in a residence will find its way into a credit shelter (or bypass) trust created on the death of one spouse for the surviving spouse’s lifetime benefit. If the surviving spouse continues to own his/her 50% interest in the residence, the owner of that partial interest can exclude that owner’s fractional portion of the gain recognized on the same of the principal dwelling. [Rev. Rul. 67-234.]

Planning Under the 2017 Tax Act: With the expansion on an individual’s standard deduction, along with the limitation of the SALT itemized income tax deduction to $10,000 a year for a married couple, one planning technique often suggested is to transfer title to a residence to an irrevocable trust which becomes a separate taxpayer with its own ability to claim income tax deductions. If other income producing assets are transferred to the trust along with the residence, then the real property taxes associated with the trust-owned residence can be claimed up to $10,000 in SALT deductions against the trust’s income for the year- an income tax deduction for those real property taxes that might otherwise be lost if the individual continued to hold title to the residence in his/her own name. For example, consider the transfer to a non-grantor trust of a vacation home or cottage that is intended to stay in the settlor’s family for multiple generations, or the transfer of a residence in to a trust that is intended to be used by a disabled family member beneficiary.  This planning strategy can work under the 2017 Tax Act, but there are a couple of caveats to keep in mind if it is adopted.

  • IRC 121 Exclusion ‘Trade-Off’: Unless the irrevocable trust is a grantor trust for income tax reporting purposes, the trust will not be eligible for the capital gain exclusion on the sale of the residence by the trustee under IRC 121. [PLR 200104005; Reg. 1.121-1(c)(3).] As such, there is a ‘trade-off’: if the irrevocable trust is a grantor trust then a sale of the residence can avoid capital gains on the sale of the residence, but then since it is a grantor trust, all income will be attributed to the trust settlor, so there will not be a second $10,000 SALT income tax deduction available to off-set the real property taxes associated with that residence. If the trust is a non-grantor trust then a second SALT tax deduction will be available (to the trust) but the trustee cannot then avail itself of the IRC 121 exclusion from capital gains if the residence is ever sold by the trustee.
  • Expenses Not Deductible: Assume an irrevocable trust is set up to hold title to a residence, to be occupied by a disabled trust beneficiary. The amounts spent by the trustee to maintain the residence are not considered to have been distributed to the beneficiary, and thus those expenses are not deductible as a distribution deduction by the trustee; i.e. the expenses are not taxed to the trust beneficiary. IRC 662(a) does not apply. Instead the trust’s income used to pay those expenses associated with the residence is taxed to the trust, potentially at a marginal 37% income tax rate. [Plant, 76 F.2d 8; AFTR 376 (CA-2, 1935); PLR 8341005.] The Tax Court has formally held that expenses paid by an irrevocable trust to maintain a residence owned by the trust but used by a trust beneficiary are not deductible either as expenses of the trust or as a deductible distribution to the trust beneficiary. [Prince, 35 TC 974 (1961).]

Practical Solution: With regard to the second identified problem of the expenses incurred with regard to the residence held in trust not being tax deductible, one solution is to draft the trust instrument to require that income distributions be made to the trust beneficiary, thus becoming deductible distributions by the trust, but taxable to the beneficiary at a much lower marginal income tax rate. [IRC 662(a).] The trust instrument would then require, as a condition to the beneficiary’s continued use of the residence, that the beneficiary must pay all of the maintenance expenses associated with the residence held in the trust. This conditional approach used in the trust will dramatically reduce the amount of income taxes paid.

Conclusion: Using an irrevocable trust to exploit the $10,000 SALT income tax deduction may make sense for a lot of families who have second homes or ‘heirloom’ real estate residences. But before moving forward with that planning step it is always a good idea to consider the other tax consequences associated with holding title to a residence in trust.